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Bank Capitalization And Cost: Evidence Of Scale Economies In Risk Management And Signaling

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  • Joseph P. Hughes
  • Loretta J. Mester

Abstract

We amend the standard cost model to account for the role of financial capital in banking. The cost function is conditioned on the level of capital, but we model the demand for financial capital so that it can serve as a cushion against insolvency for potentially risk-averse managers and as a signal of risk for less informed outsiders. Scale economies are then computed without assuming that the bank chooses a level of capitalization that minimizes cost. We find evidence of substantial scale economies and that bank managers are risk averse and use the level of financial capital to signal the level of risk. © 1998 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology

Suggested Citation

  • Joseph P. Hughes & Loretta J. Mester, 1998. "Bank Capitalization And Cost: Evidence Of Scale Economies In Risk Management And Signaling," The Review of Economics and Statistics, MIT Press, vol. 80(2), pages 314-325, May.
  • Handle: RePEc:tpr:restat:v:80:y:1998:i:2:p:314-325
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    1. Stephen A. Ross, 1977. "The Determination of Financial Structure: The Incentive-Signalling Approach," Bell Journal of Economics, The RAND Corporation, vol. 8(1), pages 23-40, Spring.
    2. Loretta J. Mester, 1994. "How efficient are Third District banks?," Business Review, Federal Reserve Bank of Philadelphia, issue Jan, pages 3-18.
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